How To Earn Tax Free Dividends On 2 Quality MLPs

MLP securities have been one of the best performing groups in recent years. From the low of 152 in November 2008, the Alerian MLP Index (AMZ) nearly tripled to the 411 peak last February. After slipping back, it has rebounded back to 400 (not far from its record). The comparable index which includes reinvested dividends is more than 12 times its starting value. Very few stocks have better performances.

MLPs supply infrastructure for the energy industry in the US and Canada. Prospects have increased substantially in recent years because of new technology used to extract gas and oil from marginal energy properties. To give an idea of the dramatic difference technology has made, oil extracted from shale will make North Dakota the #2 state (Texas is #1) supplying oil in the US this year

For those new to MLPs, it is important to understand that MLP ownership is different than owning stocks. Limited partnerships have units which pay distributions. Distributions are paid from distributable cash flow, a cash flow figure which includes net income and non-cash items (such as depreciation). Typically over 80% of distributions are not taxed in the current year, but tax issues are complex. For example, complicated S-1 tax forms are made available around early March.

Two of the largest MLPs set up companion corporations, an alternative form of ownership, which can be attractive to investors who want to avoid tax hassle. Each share of stock is backed by one unit in the partnership. Shares track unit prices and the stock dividends are based on distributions paid to unit holders. No 1099s are sent out for taxable accounts and stocks are friendly investments for retirement accounts.

Kinder Morgan Inc., the parent of MLP Kinder Morgan Energy Partners, became the largest US pipeline operator with 75,000 miles of energy pipelines after purchasing El Paso Corp. in May. KMP just announced Q2 profits fell, related to the acquisition cost for El Paso. But the quarterly distribution was increased from $1.20 in Q2 to $1.23 in Q3. Distributable cash flow, the ability to pay distributions, rose to $366 million from $324 million. Additionally, KMI, the corporate parent, increased its quarterly dividend from 30¢ to 35¢ in Q3.

Enbridge Energy Partners is a leader in energy transportation for crude oil, liquid petroleum and natural gas and operates natural gas midstream businesses in the Mid-Continent and Gulf Coast regions of the US. It owns the US portion of the world's longest liquid petroleum pipeline, transporting crude oil and natural gas liquids primarily from western Canada to refining centers in the Midwest and Ontario, Canada.

These companies have excellent records of raising distributions. KMP has been raising annual distributions aggressively since 1996. EEP was more cautious about raising distributions, but there have been no reductions since the first distribution in 1992. EEP is guiding annual distribution increases of 2-5%.

KMP and KMR yield around 6% while the parent, KMI, has a more modest 4% yield. KMI had its IPO last year and has a limited record of increasing dividends. EEP and EER yields are around 7%. Investors who need income and don't mind tax hassle will be interested in the units. However for those who don't need current income, the companion stocks, KMR and EEQ, are efficient dividend reinvestment programs with no tax consequences (until share are sold).

Retirement and other accounts which are not taxed currently have limits on unrelated business income tax (UBIT) which MLPs generate. While not generally a problem, all tax matters have the potential of becoming complex. Personal tax advisors should be consulted to properly understand tax implications. However, KMP, KMI and EEQ are corporations which pay dividends and are accepted in retirement accounts.

While capital appreciation is difficult to forecast, the Alerian MLP index has quadrupled in 17 years which indicates a bright future because the promise of growth for MLPs is as strong as it has ever been. But MLPs are primarily thought of as yield securities. Even with yields at traditionally low levels (6% for the MLP index), they are significantly above yields on most other securities. Best of all, stocks of MLP corporations have tax advantage without tax hassle.